Who Is Archegos?
March 25th, 2021 — The stock of ViacomCBS, a traditional and popular U.S.-based multimedia company, had free fallen from U$100.34 to U$66.35 in only three days (see chart below). The stock had been highly popular with investors in the months prior, nearly doubling its price. The market was left confused and desperate: the blue-chip stock was crashing without any apparent reason. At the same time, seven other completely unrelated stocks seemed to be suffering from the same condition: Tencent Music, Baidu, Vipshop, Farfetch, iQIYI, Discovery, and GSX Techedu. All stocks had tanked multiple percentage points, and as much as 42%, by Friday.
Goldman Sachs revealed to its clients on March 24th, and subsequently via Bloomberg to the rest of the world, that Archegos has been margin called. A margin call is when, translated to English, an investor defaults on the loans he made to invest in the stock market. Archegos up to this point was a small family office, headed by Bill Hwang — who was previously convicted for insider trading by the SEC in 2014. At the time, Bill’s only punishment was to close his hedge fund (called Tiger Asia) and pay a tiny fine of $44 million. From the ashes of Tiger Asia, Bill Hwang founded Archegos. It is speculated that the Archegos office had anywhere from $5 to $10 billion under management, although we may never know the true number. This was all in proprietary funds — Bill could not accept money from other investors (due to his insider trading conviction), only being able to invest his own personal wealth.
Unfortunately, that number was still not high enough for Bill. Somehow, Hwang managed to turn a wealth of $5 billion to an investment of $50 billion by using leverage with multiple banks — and it’s estimated he used 5x to 8x leverage, which means he loaned 5x to 8x more than what he had in hand (which was itself used as the margin, or in other words, collateral if he decided to default). It is fairly simple to understand what happened next: Hwang’s bets didn’t pay off and he ran out of margin to post (insurance against default), which is actually very common among hedge funds and small family offices. Sometimes, trades don’t go your way. He got a margin call by Goldman Sachs, who immediately liquidated their exposure to Hwang’s stocks — leading to the domino effect that would cause multiple billions of his stock list to be sold off in a hurry, in a practice we in the business call “fire sale”. Due to the size of their positions, this fire sale was quickly picked up by the market causing general panic amongst investors.
However, not all banks caught the signals quickly enough. As Hwang had leverage with several banks, a few of them (for example, Nomura and Credit Suisse) were too slow to margin call and liquidate their exposure — leading some of their billion-dollar investments in Hwang’s stock list to be suddenly halved. Nomura announced a loss of at least $4 to 5 billion. Credit Suisse is still counting its losses but estimated to have lost up to $8 billion. For a large investment bank with talented employees, this is not a fatal blow — but it is a pretty dangerous one. These amounts can sum up a whole year's worth of profits. In response to the Archegos losses, Credit Suisse has recently announced that its chief risk officer and its investment banking chief are both parting ways with the bank by the end of April. It is estimated Credit Suisse had to sell its Viacom shares for 40 cents on the dollar, compared to what it had paid for it in March 2021.
Archegos can’t pay back its loans. A few unlucky investment banks lost a whole quarter’s (or even a whole year’s) worth of profits. In the world of high-stakes trading, however, surprises are expected to happen. Stress-tests and risk management teams exist for a reason. Then why is everyone talking about this? The answer is simple: the more interesting question here is not why a small family office failed — but why it was allowed to take so many investment banks with it, and threaten the stability of the global financial system itself.
It is reasonable to assume that all investment banks Hwang traded with would not have taken the entire risk of Hwang’s leveraged trading by themselves. For example, Nomura would not have turned a $5bn investment into a $50bn investment with only 10% collateral from a small family office headed by an SEC-convicted trader. Even if it had, it would have been the first to margin call Hwang and save itself from multi-billion losses. What led the banks then to expose themselves to this exact risk but separately (and worse, blindly)?
“The more interesting question here is not why a small family office failed — but why it was allowed to take so many investment banks with it, and threaten the stability of the global financial system itself”
There were effectively two ways that Bill Hwang executed his leveraged trades with major investment banks: (1) he called the Prime Brokerage department and negotiated the leveraged position. This worked for small amounts of money as the banks’ liquidity and risk assessment protocols correctly worked, limiting the amount of leverage Hwang could apply for to a reasonable amount of risk that the bank was willing to take. Bill was also required to be transparent with the amount of leverage he owned through this mechanism, which would stop other banks from giving him even more leverage in the same positions. There was however a second (and primarily responsible for this financial hiccup) that Bill used to leverage: (2) Total return swaps.
Let’s unpack that word: swaps are financial contracts where two parties agree to swap their payment rates. For example, if I take out a fixed-rate loan (such as a mortgage with a 2% interest rate), and I believe the interest rate is going to decrease in the next few years. I might take the advantage of an interest rate swap, which would be equivalent to me approaching a friend — or a bank — and offering the following contract:
“I have to pay my 2% interest rate every year for my house. What if you paid my interest rate for me and I paid you a variable rate (which we can agree upon)? If the variable rate is 3% (higher than the fixed leg of 2%) then I will pay you 3% and you pay me 2%. If the variable rate is lower, such as 1% — then I pay you 1% and you pay me 2%”
In such a contract, both parties are effectively swapping the interest rate responsibilities. In the real world, this is usually done through a cash settlement — which means instead of “you pay me 3%, I pay you 2%”, we only take the difference between the two rates and pay who deserves to be paid. A bit like if your roommate owes you money for toilet paper, and you owe her money for coffee cups, you can just take the difference between what you both owe each other and only one person has to pay the other (in this case, probably you since coffee cups are more expensive than toilet paper).
The “total return” part of this contract refers to the underlying asset (which in our example was a mortgage interest rate). This would refer to stocks or stock indices. One party pays the other the total returns of the stock (dividends + capital gains) and the other pays a set rate (which can be either variable or fixed but don’t focus on that). In Archegos’ case, the bank paid the total returns of the stock to Archegos and Archegos paid the set fee to the bank. Because Archegos didn’t actually have to buy the stock, it could both (1) leverage its position and (2) build a position on a stock without the market knowing about it. That way, Archegos could enter multiple total return swaps with multiple banks for the same stocks without any other banks knowing about this. When Archegos couldn’t afford to pay the set fee anymore — everything went south.
Although the banks made decent fees from this arrangement, it quickly became clear that the fallout was exponentially larger than any fee they could have gotten from these swaps. The blind risk taken on this incident — the banks, the individual investors who had no idea such a large percentage of the stocks were owned by one person, the regulators, and the financial system itself — was not worth it. This is one of the rare instances in the financial world where nobody benefited from financial irresponsibility and lack of transparency. The SEC has launched an official investigation into Bill Hwang and its derivatives trading, but we are yet to hear about more solid regulations that can once and for all demand transparency to the markets, and end loopholes that currently allow even the smallest players to cause major systemic scares. Family offices are still one of the least regulated financial players — Amy Lynch, a former SEC regulator, told CNBC News that the “Archegos episode may not be an isolated event”. However, it remains clear that the financial system cannot afford to let the Archegos episode repeat itself.